The Gold Demand Mystery

The rally in gold that began in January has stunned most money managers.
They were predicting a horrible year for gold in 2014, and a great year
for US stock markets.

So far, they are dead wrong.

The Dow has gained no ground, while gold, silver, and precious metal stocks
have performed like champions.

From a fundamental perspective, the main sources of gold demand are Indian
and Chinese gold jewellery buyers, Western retail clients, institutional
money managers, and central banks.

What of these sources of demand is responsible for the current "steady
as she goes" gold price rally?

Well, the daily change in gold held by the SPDR gold fund is a superb
indicator of Western liquidity flows into and out of gold bullion.

Please click
here now. I've highlighted the daily change in SPDR tonnage in this
table. For the month of January, the holdings were essentially unchanged. While
they were not a negative factor, Western ETF buyers were clearly not
the key driver of the January gold market rally.

Please click
here now. That's a look at SPDR tonnage for the month of February.
It increased by about 20 tons. That's a decent jump, but mine and scrap
supply amount to more than 300 tons a month, so investors need to look
at other sources of demand, for the main key to this rally, and to
understand whether it can continue.

Official central bank holdings don't appear to have changed much in 2014.
China seems to have imported about 80 tons in January, and probably produced
about 30 - 40 tons internally. Demand is definitely very strong in China,
but it doesn't exceed global supply.

Over the recent two month period, hedge funds appear to have increased
their long position by about 50,000 contracts (roughly 150 tons), but
commercial traders have increased their short position substantially.

The bottom line is that hedge fund buying is strong, but when balanced
against commercial selling and shorting, it was not the factor that moved
the gold price substantially higher.

Please click
here now. Mineweb reports that Mumbai traders believe official Indian
imports for January were in the 40 ton area. That's definitely not enough
to overwhelm supply.

The Central Bank of India and the World Gold Council (WGC) have both indicated
that gold smuggling could quickly become a major issue in that nation,
like it was in the 1990s. The WGC has estimated that perhaps 200 tons
of gold were smuggled into the country in 2013.

That's a significant number, and I would argue most of that probably occurred
in the second half of the year, after the Indian government and central
bank imposed draconian import restrictions during the first half of the
year.

The bottom line is that smuggled gold going into India in 2013 probably
did so at the staggering rate of about 40 tons a month. In my professional
opinion, that number is probably still rising, and it could go even higher
in 2014.

I believe that most of investors in the Western gold community would agree
that gold feels solid here. It feels like a mysterious floor of substantial
demand is supporting the market on all sell-offs, yet the source of
that demand is opaque.

Many technical indicators on both the daily and weekly charts are flashing
sell signals at nosebleed levels, yet gold refuses to slide in a material
way. Is it possible that Indians have lost patience with broken government
promises to lessen the draconian gold import duties? I think so.

Gold is off to another great start this morning. To view the daily gold
chart, please click
here now. Despite being at nosebleed levels, my stokeillator at the
bottom of the chart seems to be trying to flash a fresh buy signal.

A number of lead technicians at major banks have suggested that if gold
rises above $1361, it could quickly surge to $1432. I think it would hesitate
in the $1375 area, but $1432 is a critical number. If gold rises above
the highs in the $1432 area, it would probably attract enormous institutional
interest.

Institutional money managers are more concerned about inflation now than
financial system risk. That means they are likely inclined to buy gold
stocks rather than bullion. So far in 2014, gold stocks are dramatically
outperforming gold, and I think that outperformance has barely started.

Until now, I've always been able to identify the fundamental source of
demand that has created gold market rallies. It's unknown whether Indian
black market demand is the prime driver of the current gold market rally, but
none of the other catalysts seem to be producing that kind of demand.

The motto of the Indian Bullion and Jewellery Association (IBJA) is "We,
The Team". Is gold entering a new era, where Chinese and Indian gold
jewellery demand for gold bullion combine with Western gold community
mining stocks, creating a long-term rise in the price of both asset classes?

On that note, please click
here now. Note the incredible symmetry between the two congestion
patterns on this daily GDX chart. There was a powerful momentum-style
buy signal generated by the stokeillator as gold stocks began to rally
out of the first pattern. Is it about to happen again? I think so, and
I hope the Western gold community is fully poised to profit handsomely!

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Stewart Thomson is a retired Merrill Lynch broker. Stewart writes the
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